Bernanke Changed Course

PHILOSOPHER KING Fed chairman Ben Bernanke testifying before Congress in July, just as signs of trouble began to appear.

Image: Joshua Roberts

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Despite all that has been written about the summer credit crunch, the biggest mystery in the financial markets is still this: Who rolled Ben Bernanke?

In early August, as turmoil in the market for subprime mortgages generated big losses at hedge funds and other financial institutions, the Federal Reserve chairman and his colleagues pumped a bit more cash into the system but refused to be panicked into lowering interest rates—a stance that outraged some Wall Street traders.

For another couple of weeks, Bernanke stood firm. After a meeting on August 7, the Fed’s Open Market Committee kept interest rates steady. A week later, William Poole, the president of the St. Louis Fed, said only a “calamity” would justify a cut in interest rates before the committee met again in mid-September. “Nobody has called up and said the sky is falling,” he said.

And then, only two days later, everything changed. Bernanke abruptly reversed course, announcing a cut in the discount rate—the rate at which the Fed lends money to commercial banks—from 6.25 percent to 5.75 percent. In its statement, the Fed said it was “prepared to act as needed to mitigate” the impact of the subprime meltdown. Sure enough, on September 18, the Fed trimmed the federal funds rate—which banks charge one another for overnight loans—by a half of a percentage point, to 4.75 percent, a bigger cut than expected, and also cut the discount rate by another half a percentage point.

The mystery of why Ben Bernanke changed course will be debated for months. But the solution may turn out to be as simple as this: The Fed chairman found himself sandwiched between his academic beliefs and the real world. While he might have liked to teach investors a lesson about the theoretical costs of risk, in reality the economy was, and still is, shaky. So when Wall Street stood up to the chairman, he caved.

On August 21, he went to Capitol Hill, where he took part in a photo opportunity with Hank Paulson, the former Goldman Sachs C.E.O. who serves as Treasury secretary, and Christopher Dodd, who heads the Senate Finance Committee and whose faltering presidential campaign has received pots of money from hedge funds and investment banks. Both men had a direct interest in seeing the Fed cut rates. “Chairman Ben Bernanke looked more like a Taliban hostage than an independent central banker,” Willem Buiter, a London School of Economics professor who has served on the Bank of England’s monetary-policy committee, said on his blog.

Buiter has a point. Between them, Paulson and Dodd boast more than half a century of experience on Wall Street and in Washington. Bernanke’s entire policy career before he took over as Fed chairman in February 2006 consisted of three years serving under Alan Greenspan as a Fed governor and six months as chairman of the White House Council of Economic Advisers. Neither post conferred much executive authority.

To be fair, Bernanke, who has published dozens of academic papers on monetary policy and co-authored a lucid macroeconomics textbook, is a more than able economist and, by all accounts, a very decent individual. But academic learning, while arguably a necessary condition for being a successful central banker, is certainly not a sufficient one. The last Fed chairman with credentials similar to Bernanke’s was Columbia University’s Arthur Burns, who bowed to strong pressure from the Nixon White House and kept interest rates low, allowing inflation to get out of hand.

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